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February 19, 2008

How Canst Thou Know Thy Counterparty When Thou Knowest Not Thine Self?

John P. Hussman, Ph.D.
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In late-2003, I published a piece called Freight Trains and Steep Curves explaining why lenders were willing to provide funds to finance a growing mountain of very risky debt at such low interest rates. I detailed how interest rate swaps and credit default swaps were being used to present lenders with “safe” instruments “that end up being partially backed by the U.S. government . These are held by investors precisely because they piggyback on the good faith and credit of Uncle Sam.”

“Now make no mistake, there is little question that bank deposits and agency debt are safely backed by the U.S. government and that this is a good commitment. However, the holders of stock in banks or mortgage companies like Fannie Mae and Freddie Mac may not be so secure. It's just excruciatingly difficult to perfectly match risky assets and liabilities at extremely high levels of leverage. Ask Long Term Capital. Indeed, were it not for accounting rules that allow Fannie Mae to keep balance sheet losses out of earnings, it would be clearer to investors that last summer's 5-month “duration mismatch” cost Fannie nearly a year of earnings. Similar derivatives-related issues are at the core of Freddie Mac's recent difficulties. [Fannie and Freddie have each lost over 60% of their value since that piece was published].

“According to the Bank for International Settlements, the U.S. interest rate swap market is about $34 trillion in size, having nearly doubled in size in the past two years. The reason this figure is so enormous is that there are usually several links in the chain from borrower to investor. A risky borrower may enter a swap with bank A, which then takes an offsetting swap position with bank B (earning a bit of the credit spread as its compensation), and so on, with a cheerful money market investor at the end of the chain holding a safe, government backed security, oblivious to the chain of counterparty risk in between.

“Picture a freight train.

“Aside from the risk that any particular link in this chain might be weak (know thy counterparty), the U.S. financial system has gone one step further. In order to hedge against the risk of defaults, banks frequently lay credit risk off by entering “credit default swaps” with other banks or insurance companies. These swaps essentially act as insurance policies for credit risk.

“Once again, however, the iron law of equilibrium is that every risk swapped away by someone is held by someone else. According to Bloomberg, over half of the world's trading in the credit swaps market is concentrated among five banks: J.P. Morgan (26%), Citigroup (10%), UBS Warburg (9%), Bank of America (7%) and Deutsche Bank (7%). As Warren Buffett has noted, ‘Large amounts of risk, particularly credit risk, have been concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one another. The trouble of one could quickly infect the others.'

“Picture a freight train.”

I concluded that “to the extent that economic strength could raise short-term interest rates, velocity and inflation in the near term (regardless of Fed action), the heavy dependence of risky debtors to low interest rate credit could trigger a fresh acceleration of defaults in the longer term.”

As we enter 2008, the excessive creation of risky debt is beginning – and I should emphasize only beginning – to produce writedowns and losses. Though that “Freight Trains” piece has played out largely as expected, the situation has been complicated by a prolonged housing bubble that has only made the debt imbalances worse. Having observed the inflation pressures I had anticipated over the near term, we are now starting to observe the credit problems I had anticipated over the longer term. Probably the only “bright side” is that increasing credit difficulties can be expected to put downward pressure on inflation later this year. Periods of heightened credit concerns tend to increase the demand for government liabilities (e.g. currency and Treasury securities), which tends to lower monetary “velocity” enough to drive down the rate of inflation.

Since 2000, the market for credit default swaps has exploded by a factor of 50, to $45.5 trillion. A front-page article in Sunday's New York Times (Arcane Market is Next to Face Big Credit Test) notes that about one-third of credit default swaps provide insurance against the default of a particular corporate borrower, about 30% are written against indices representing baskets of debt from numerous issuers, and among those used for other purposes, about 16% are intended “to protect holders of collateralized debt securities, complex pools of bonds that have recently experienced problems because of mortgage holdings.”

Last week, AIG was hit hard when it admitted it could not “reliably quantify” its losses on these credit default swaps. One wonders how companies can have much sense about the risks of their counterparties when they cannot reliably quantify their own.

I continue to believe that there is substantial risk of audit delays and “qualified” opinions in the upcoming reports of financial companies. It is difficult to see how analysts and some financial news anchors can seriously be looking for the market to have “discounted the bad news” when companies are still at a loss to quantify their news at all. It is equally difficult to see how financials can “come clean” with their losses when those losses generally have not yet occurred because the major wave of mortgage resets that started in October probably only now beginning to produce delinquencies. It's impossible to know yet which mortgages and how much will end up in foreclosure.

Most likely, there is more turbulence to come.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action, holding the Strategic Growth Fund to a fully hedged investment stance. The market has not advanced to a point where it is clearly overbought, however, so I have no particular views regarding near term market direction. There is no reason the market cannot enjoy a further rebound for a few more weeks (at least until the point where it again becomes overbought), but investors should be aware that market conditions are not at all supportive, so abrupt declines will be rather easy to generate on various pieces of discouraging news. As usual, our investment positions are set based on the average return/risk profile that can be expected from a particular set of market conditions. Accordingly the Fund remains fully hedged for now.

As a side note in the equities markets, Dow Jones has decided to alter the composition of the Dow Jones Industrial Average by replacing Honeywell and Altria with Bank of America and Chevron. For investors familiar with the contrary record of this sort of substitution, we can take this as a modestly favorable indication for technology and consumer stocks, relative to the prospects for financials and oils. It has been repeatedly and reliably true that stocks kicked out of the Dow and S&P 500 have outperformed the new entrants. Bill Hester wrote a nice research piece on this a few years ago (Misfit Stocks). Recall that in April 2004, International Paper, Eastman Kodak, and AT&T were kicked out of the DJIA, in favor of AIG, Pfizer and Verizon. While IP and Kodak have generally languished, AT&T has done well enough to pull the rejected group to a slight gain of about 5%. In contrast, AIG and Pfizer have taken major hits, with the three entrants averaging an overall loss of about 25% since their inclusion in the DJIA.

In bonds, the Market Climate was characterized by unfavorable yield levels and neutral market action. Bond yields have spiked somewhat in recent weeks. We should not be surprised by the same general “sawtooth” trend that I've described in recent months: a general (somewhat diagonal) downtrend in rates based on emerging economic weakness, punctuated by fairly sharp vertical spikes, typically on inflation news, with the overall result being a relatively flat trading range over time. Again, that's an impression, not an expectation that we would use to drive investment positions. Currently, the Strategic Total Return Fund holds an unusually short 1-year duration exposure, mostly in short-duration Treasuries, with about 20% of assets in precious metals shares. As I've noted before, precious metals shares have historically achieved particularly strong returns when there is downward pressure on real interest rates, the economy is weakening, and the gold/XAU ratio is above 4.0 (it is currently above 5.0, which is exceptionally rare and generally associated with strong subsequent returns). That said, precious metals shares tend to be extremely volatile, so our exposure of just over 20% reflects both potential return as well as probable volatility.

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