Saturday, August 22, 2009

Weekend Links: The Zero Hedge Edition

Zero Hedge has been on fire recently. There are far too many posts and links to read if you have a full time job. This is why you have me, a soon to be student, to sort through and separate out the best articles. Accordingly, in honor of a great week of content, all of the following links appeared on or are courtesy of Zero Hedge.

On a brief side note, until recently I had been wondering how in the world Tyler Durden posts so much. I am lucky if I get one post out in a day considering how much reading and research each one requires. Upon more reflection I realized (probably much later than I should have) that there are obviously many Tyler Durdens. I know the author is not the focus, the content is. However, for once I actually agree with Felix Salmon’s idea that Zero Hedge should be disaggregated. They could all have Fight Club pseudonyms as far as I am concerned. They could name themselves after Sesame Street characters for all I care. In fact, I would love Cookie Monster and Oscar the Grouch pseudonyms. But just like I read Buttonwood (I just realized that I unconsciously assumed that this is the same writer each week but I have no evidence to that effect) each week in The Economist, I would like to be able to follow the writers that touch on the themes that I am interested in. I don’t think it devalues the content and it would help me pick and choose the articles that I think are most insightful.

Leaders use the Black Swan as a way to avoid blame: In this piece from Chris Whalen of Institutional Risk Analytics he discusses Taleb’s idea of the Black Swan and makes the very insightful point that the concept has been applied to way too many things that actually were not unpredictable or unforeseeable. In fact, he sees the democratization of the word as a way to abdicate responsibility for bad policy decisions by our leaders:

Policymaker would like everyone to believe that the recent crises were random unpredictable Black Swan events. How can they be blamed for failing to anticipate a low probability, random, and unpredictable event? If on the other hand, the crises had observable antecedents, e.g. increased use of leverage, maturity mismatches, near zero default rates, and spikes in housing price to rental rates and housing price to income ratios, then one must ask: why policymakers did not connect the dots, attach significant higher than normal probabilities to the occurrence of severe financial disturbances, and fashion policies accordingly? Ultimately, that is a question that Ben Bernanke and the rest of the federal financial regulatory community still have yet to answer.

As investors we can’t forget the role that things like the Fannie Mae and Freddie Mac policy decisions had in creating the housing crisis and ensuing economic collapse. It is hard to argue that the implosion of entities levered 80-1 was a Black Swan. We need to hold our leaders accountable. This includes the regulators, Congress, and the Fed.

The SEC hints that it is expecting more transparency: In this letter to “certain public companies” the SEC has subtly warned these financial institutions that it expects more transparency in the future regarding balance sheet valuations and associated provisions of some of their dodgiest loans:

After failing as a regulator, the SEC is now officially an accountant. In a letter disseminated to "certain public companies", the SEC's Senior Assistant Chief Accountant is providing a gentle yet firm request that companies provide substantially more clarity and transparency when it comes to provisions and allowances for loan losses. For now, the SEC appears focused on option ARM products, junior lien mortgages, high loan-to-value ratio mortgages, interest only loans, subprime loans, and loans with initial teaser rates.

The SEC also has asked these companies to provide some more detail in terms of changes in their practices. Meaning that when a bank decides to change its non-performing requirements from 90 days to 180 days the SEC wants to know why. Sounds reasonable enough. Finally, the SEC wants some information about how the decline in collateral value has impacted loan books. In other words it wants to understand how it is possible to carry a loan at 100 cents on the dollar when the value of the house has dropped 50%, the buyer is massively under water and there is no demand from buyers. These are simple questions that many of us want answered. But the truth may not be pretty if the banks actually decide to be (or are forced to be by the FASB) more forthcoming.

Los Angeles and Long Beach ports see dramatic declines in shipping: Confirming the rationale behind the recent drop in the Baltic Dry Index, California ports have recently reported significant overall declines in the number of containers shipped:

Imports at Los Angeles, the nation's busiest port, were down 16.9% to 305,226 cargo containers compared with a year earlier. Overall for the year, traffic is down 15.9% to 3.77 million containers, counting imports, exports and the number of empty boxes that leave the port bound for Asia.

Imports at the nation's No. 2 port, Long Beach, were down even more sharply in July compared with a year earlier, by 18.6% to 221,719 containers. Overall cargo traffic at Long Beach is down 26.8% for the year to 2.77 million containers.

Shipping used to be a valuable indicator of the health of the economy but the stock market does not seem to care about the declines in both rail and sea-based shipping. However, even more troubling, a recent report indicated that this time we may not see anything like a V-shaped recovery in shipping:

Among the report's many points is that this recession is far more complicated than the economic downturns following the dot-com bust and the 9/11 terrorist attacks, after which pent-up consumer demand rather quickly returned the economy to relatively normal levels.

This time, no such pent-up demand exists. Instead there has been a fundamental lowering of financial capability, according to the report, produced for the ports by consulting firms Tioga Group and IHS Global Insight.

Finding real green shoots is getting harder and harder. Maybe there are some legitimate ones out there but they are being weighed down by reams of data like this.

Andy Xie drops the hammer: In the latest piece from my favorite columnist, Andy Xie tries to dispel the idea that the global economy is going to see a quick, run of the mill inventory restocking recovery:

In a normal economic cycle, an inventory-led recovery would be followed by corporate capital expenditure, leading to employment expansion. Rising employment leads to consumption growth, which expands profitability and more capex. Why won't it work this time? The reason, as I have argued before, is that a big bubble distorted the global economic structure. Re-matching supply and demand will take a long time.

The process is called Schumpeterian creative destruction. Keynesian thinking ignores structural imbalance and focuses only on aggregate demand. In normal situations, Keynesian thinking is fine. However, when a recession is caused by the bursting of a big bubble, Keynesian thinking no longer works.

Many policymakers actually don't think along the line of Keynes versus Schumpeter. They think in terms of creating another bubble to fight the recessionary impact of a bubble burst. This type of thinking is especially popular in China and on Wall Street. Central banks around the world, although they haven't done so deliberately, have created another liquidity bubble. It manifested itself first in surging commodity prices, next in stock markets, and lately in some property markets. Will this strategy succeed? I don't think so.

Xie’s thoughts echo those of many of the people that I follow who don’t believe creating liquidity will alleviate what has become a balance sheet recession in which solvency is the main problem, not liquidity. Accordingly, he doesn’t have high hopes for how long this liquidity euphoria will continue:

A pure bubble tied to excess liquidity that affects one or many financial assets cannot last long. Its multiplier effect on the broad economy is limited. It could have a limited impact on consumption due to the wealth effect. As it neither stimulates the supply side nor boosts productivity, whatever story it is based on will have holes that become apparent to speculators. It doesn't take long for them to flee. Furthermore, a pure liquidity bubble without support from productivity can easily lead to inflation, which causes tightening expectations that trigger a bubble's burst.

What we are seeing now in the global economy is a pure liquidity bubble. It's been manifested in several asset classes. The most prominent are commodities, stocks and government bonds. The story that supports this bubble is that fiscal stimulus would lead to quick economic recovery, and the output gap could keep inflation down. Hence, central banks can keep interest rates low for a couple more years. And following this story line, investors can look forward to strong corporate earnings and low interest rates at the same time, a sort of a goldilocks scenario for the stock market.

The problem with this story according to Xie is that eventually the government will be forced out of the business of creating liquidity and printing money by higher interest rates and the result will be a double dip recession. Between these words and those of guys like Roubini, if it plays out that way please do not try to claim it was a Black Swan. Consider yourself warned and try to make sure your portfolio is hedged for another tail event.

Accounting change on deferred acquisition costs could be bad for insurers: Bloomerg’s Jonathan Weil has recently done a tremendous job of highlighting conditions in the financial markers that no other media outlets are discussing. In his latest piece, he highlights a potential upcoming problem for insurance companies:

Look at the asset side of Lincoln National’s balance sheet, and you’ll see a $10.5 billion item called “deferred acquisition costs,” without which the company’s shareholder equity of $9.1 billion would disappear. The figure also is larger than the company’s stock-market value, now at $7 billion.

These costs are just that -- costs. They include sales commissions and other expenses related to acquiring and renewing customers’ insurance-policy contracts. At most companies, such costs would have to be recorded as expenses when they are incurred, hitting earnings immediately.

Because it’s an insurance company selling policies that may last a long time, however, Lincoln is allowed to put them on its books as an asset and write them down slowly -- over periods as long as 30 years in some cases -- under a decades-old set of accounting rules written exclusively for the industry.

Those days may be numbered, under a unanimous decision in May by the U.S. Financial Accounting Standards Board that has received little attention in the press. The board is scheduled to release a proposal during the fourth quarter to overhaul its rules for insurance contracts. If all goes according to plan, insurers no longer would be allowed to defer policy-acquisition costs and treat them as assets.

The board already has decided such costs aren’t an asset and should be expensed. If that holds, it wouldn’t make sense to let companies keep their existing DAC intact.

There is no telling what the FASB will eventually decide to do. It is hard for me to believe that in such tenuous times the FASB would really consider wiping out a large portion (if not all) of these companies’ shareholder’s equity by changing the classification of these DACs. I’m not even sure what would happen because if these costs have already been realized they logically are not liabilities. So, as opposed to retroactively wiping assets off of the balance sheets of these companies, I would not be surprised to see the FASB rule that DACs will not be treated as assets (and therefore must be fully expensed immediately) going forward. While this would only affect the balance sheet in the sense that over time the DACs would run off and would not be replenished, it could have a more near term impact on earnings.

Another plug for cautious optimism: In this piece by Jeffrey Bronchick of Value Expectations, he makes a very Klarman-like point that it is important to invest bottom’s up but worry top down. He seems to feel that macro considerations will continue to impact the market and therefore cannot be totally dismissed by investors. However, this does not mean we should all become macro forecasters and try to predict the impact of political and economic policies. It just means that we should all be willing to accept lower returns if in fact it takes a few years for companies bought at attractive valuations to reach their potential:

But while we are all in some ways victims of our circumstances, we do sense that bigger picture items seem to loom larger today than perhaps at anytime since the early 1980s, and while our tendency has always and correctly been to focus on the micro issues of business/value/people, there are a number of enormous “unprecedented” things going on the world that seem to want to impinge on our process. From 1982 through 2007, there was a global explosion of worldwide wealth no matter how you distribute it. The global backdrop trends were declining inflation and interest rates, increasing globalization, less taxation at both the business and personal level, less regulation and a sublimely low cost basis from which to begin a rally. It is now hard to argue that most of these trends have flat-lined at best, and raises negative thoughts that push decent economic activity past the time horizon of many investors.

But we just can’t shake a stubborn belief (well supported by history) that buying a reasonably diversified mix of good businesses at cheap to reasonable prices remains the way to long-term wealth creation on an after-tax, after-possible inflation basis…If the economy takes four more years to get going versus something positive in 2010, then we will be sitting on our performance duffs for longer than desirable. At current prices most of our stocks have livable downside within the context of a longer time horizon, but material upside in a return to a decently growing economy. Your investments should be similar to what someone has said about marriage – start with low expectations, you won’t be disappointed.

The rich may not be getting richer: In spite of the data that indicates that the rich are much less affected on a relative basis by recessions, this article in the NY Times suggests that at least they are not getting richer while most people are becoming poorer.

But economists say — and data is beginning to show — that a significant change may in fact be under way. The rich, as a group, are no longer getting richer. Over the last two years, they have become poorer. And many may not return to their old levels of wealth and income anytime soon.

Last year, the number of Americans with a net worth of at least $30 million dropped 24 percent, according to CapGemini and Merrill Lynch Wealth Management. Monthly income from stock dividends, which is concentrated among the affluent, has fallen more than 20 percent since last summer, the biggest such decline since the government began keeping records in 1959.

The problem, of course, (as discussed in the above linked piece by Tyler Durden) is that the rich drive US consumer spending despite being a huge minority. When that fact is combined with a disproportionately over-levered middle class, the prospects for spending in the coming years are dismal. However, this could be a lasting trend as some of that wealth accumulated during the boom may not come back:

“We are coming from an abnormal period where a tremendous amount of wealth was created largely by selling assets back and forth,” said Mohamed A. El-Erian, chief executive of Pimco, one of the country’s largest bond traders, and the former manager of Harvard’s endowment.

Some of this wealth was based on real economic gains, like those from the computer revolution. But much of it was not, Mr. El-Erian said. “You had wealth creation that could not be tied to the underlying economy,” he added, “and the benefits were very skewed: they went to the assets of the rich. It was financial engineering.”

Be prepared for the new normal to include less consumer spending and potentially lower GDP growth. This probably won’t be the end of the world. It is just the inevitable result of the popping of a leverage bubble.

(Picture courtesy of