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May 11, 2009

Banks Pass Stress Test - Regulators Fail Ethics Test

John P. Hussman, Ph.D.
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Just a performance note – on Wednesday and Friday, we observed normal pullbacks in a large number of our top holdings, all well within their recent trading ranges. However, this was coupled with frantic short-covering in financials, which drove the S&P 500 higher at the same time our holdings were pulling back. This gap in performance between stocks that we own and stocks that we don't own (but are still in the indices we use to hedge) is known as a “basis widening.” These generally leave us feeling like we've been on the rack in a Medeival dungeon. But we've seen these before, and they often reverse themselves over the course of a few days or weeks. The main factor to note is that the pullbacks across our largest holdings have been run-of-the-mill. The driving factor was the short squeeze in financials on the notion that the stress tests were an “all clear” signal. The modest “anti-hedge” we have in index calls was not sufficient to offset the spike in financial companies, many which remain nearly insolvent.

With regard to the recent market advance, as I noted in the December 15, 2008 comment (Recognition, Fear and Revulsion):

“While we've seen a good deal of fear, the stock market tends to go through a great deal of sideways action after panics like we've observed. It's likely that stocks will trade in a very wide 25-35% range for months. We have to be particularly observant as stocks approach the higher end of that range.

“Bear markets tend to experience a series of separate lows on what I'd call recognition, fear, and revulsion. The first selloff of a bear market is on “recognition” – the growing awareness among investors that “boom” economic conditions are in question. Investors generally continue to deny the likelihood of a bear market or a recession, so the phrase “healthy correction” usually comes up a lot. Unlike true “healthy corrections,” however, these periods tend to begin from untenable valuations, overbought conditions, generally rising interest rates, and deteriorating market internals.

“Strong intermittent advances are typical during bear markets, and can often achieve gains of 20% as we've seen in recent weeks, and sometimes substantially more. But the very existence of bear market rallies can be a problem for investors, because they clear the way for fresh weakness. The scariest declines in bear markets are typically the ones when investors think they are making progress and recovering their losses, only to see stocks go into a new free-fall.

“The “fear” lows in a bear market are probably the most variable because they are the most tied to actual economic news and events. These lows are generally associated with distinct negative developments in earnings, the economy, or in 2001 for example, world events. The fear-type lows are damaging to the long-term discipline of many investors, because the negative news encourages them to question the viability of the economy itself.

“Those “fear” lows are typically followed by powerful bear market rallies, which then clear the way for fresh declines. My impression that investors experience such declines as if they are additional major losses, even if they result in only modest new lows. In other words, if the market declines by 20%, followed by a 15% advance, and then by another 20% decline, the second drop may be experienced with the same pain as the first one was, even though it's little more than a retracement.

“That cycle of decline, followed by hope, followed by fresh losses, is really what ultimately puts a final low in place. The final decline of a bear market tends to be based on “revulsion” – a growing impatience among investors who conclude that stocks are simply bad investments, that the economy will continue to languish, and that nothing will work to help it recover. Revulsion is not based so much on fear or panic, but instead on despair and disillusionment. In a very real sense, investors abandon stocks at the end of a bear market because stocks have repeatedly proved themselves to be unreliable and disappointing.”

It would be very convenient if it was possible to buy the fear lows, participate in the bear market rallies, sell at the peaks, and repeat. Unfortunately, “fear” lows are only evident in hindsight, because as we saw in 2008, a deeply oversold market can become spectacularly more oversold before recovering, and the “fast, furious” spikes off of those lows are often followed by steep failures. Fear lows are only easy to identify in hindsight.

Even if we have observed the ultimate lows of this downturn (which I would not take as given), it does not follow that the decline we've observed over the past 18 months will be progressively recovered without a great deal of intervening difficulty. The S&P 500 has retraced just over 25% of its bear market loss. The 904 level on the S&P 500 was a 25% retracement, and 977 would be a 1/3 retracement, which is not unreasonable. Aside from such retracements, the idea of a “V-shaped” recovery in the market is strongly odds with “post-crash” market behavior, which generally features a long and drawn-out flat period for years afterward. Given the enormous overhang of Alt-A and option-ARM resets scheduled to begin later this year, extending into 2012, such a profile would not be surprising in the present case.

To put the current downturn into similar context, the chart below overlays several historical crashes, with the time scale measured in months. The downturns include the Great Depression (purple), the Japanese Nikkei index which peaked in 1989 (blue), the gold market which peaked in 1980 (green), and the S&P 500 which peaked in 2007 (red). Thanks to Bill Hester for preparing this overlay.

Note that during all of these downturns, the markets did experience very powerful intervening advances as well (indeed, the rally off of the initial 1929 market crash approached 50% before failing). In each case, however, the fundamentals of the preceding bubble had been broken and it took years for the markets and economy to adjust. In the case of gold, the shift in fundamentals was the end of double-digit inflation. In the other instances, including the present one, the shift was from a steeply leveraged economy to a deleveraging one.

To a great extent, the optimism of investors is based primarily on economic “flow” data (spending, job losses, confidence measures) that remain poor, but have been “less bad” than expected. What concerns me far more, however, is that there is a second and almost equivalent mountain of mortgage resets and probable defaults that will begin later this year and extend into 2012. While our unelected bureaucrats have spent over a trillion dollars to make reckless lenders whole, they have done nothing to materially ease foreclosures or avert the oncoming second wave.

To quote Stevie Wonder,

We're all amazed but not amused
by all the things you say that you'll do
Though much concerned but not involved
with decisions that are made by you
But we are sick and tired of hearing your song
Telling us how you are gonna change right from wrong
'Cause if you really want to hear our views
You haven't done nothin'

Jackson 5, joi-n ‘long in, ya say doo de wop…

Banks Pass Stress Test - Regulators Fail Ethics Test

Last week, financial stocks enjoyed a powerful advance and short squeeze on the announcement of the results of the “stress test” of major banks. It is important to begin by noting that this was not a regulatory procedure with teeth. It was initially a response to Congressional demands to introduce greater objectivity into the use of public capital for these bailouts, and gradually morphed into nothing more than a “confidence building” exercise. And keeping with the emphasis on keeping the numbers happy, as opposed to providing full and fair disclosure, the Wall Street Journal reported on Saturday, “The Federal Reserve significantly scaled back the size of the capital hole facing some of the nation's biggest banks shortly before concluding its stress tests, following two weeks of intense bargaining. In addition, according to bank and government officials, the Fed used a different measurement of bank-capital levels than analysts and investors had been expecting, resulting in much smaller capital deficits.”

To some extent, it is not possible to get full and fair disclosure using the method that regulators used in the first place, since it relied on banks' self-estimates of their potential losses in a further economic downturn. These of course being the same banks that made the bad loans, and have already proved themselves vastly incapable of loss estimation and risk management. Moreover, the Fed only asked for loss estimates for 2009 and 2010, not beyond – “Each participating firm was instructed to project potential losses on its loan, investment, and trading securities portfolios, including off-balance sheet commitments and contingent liabilities and exposures over the two-year horizon beginning with year-end 2008 financial statement data.” This period specifically excludes the window where we can expect the majority of “second wave” mortgage losses to be taken, as it does not capture any losses that will emerge as a result of mortgage resets from mid-2010, through 2011, and into 2012.

The “stress test” procedure also conveniently excludes any potential mark-to-market losses during 2009 and 2010, as banks “were instructed to estimate forward-looking, undiscounted credit losses, that is, losses due to failure to pay obligations (‘cash flow losses') rather than discounts related to mark-to-market values.”

Now, just think of this for a minute. Even if you assume that the “risk-weighted assets” of the banks are about two-thirds of their total assets (as the stress-test does), we're still looking at $7.8 trillion in total assets at risk in these banks, and despite being on the edge of insolvency only weeks ago, we are asked to believe that they will need less than 1% of this amount – $74.6 billion – of additional capital even in a worst case scenario. How do the stress tests arrive at this conclusion? 1) They underestimate potential losses by minimizing the horizon over which the losses would have to occur, excluding potential mark-to-market losses and restricting the loan losses to “cash flow” losses only; 2) They define capital well beyond tangible sources, to include about double what is available as Tier-1 common; 3) They include $362.9 billion in “resources other than capital” – essentially pre-provision net revenue expected to be earned by the banks over the coming two years to absorb potential losses; 4) They report the capital buffer that would be required after massive dilution in the common stock of these banks has already occurred.

As an example, Citigroup comes in with $119 billion in capital ($22 billion as Tier-1 common). Total assets are over $2.1 trillion, but the stress test assumes “risk weighted” assets of less than half that. Citi projects losses in 2009 and 2010 of $104.7 billion in a scenario where the unemployment rate reaches 10.3%. Citi assumes that it will earn $49 billion during that period which would partially absorb those losses, and that it will obtain $87 billion in Tier-1 from other capital sources, presumably including $33 billion of preferred that it would be willing to convert to common. Of course, Citi's entire market cap is only $22 billion, so the “$5.5 billion” that Citi is reported to need under the stress test is what it would require after a 5-to-1 dilution in its common stock (87+22/22). Essentially, we've got a company with a common equity buffer of just over 1% of total assets, that just 8 weeks ago was on the verge of receivership, and investors are urged to believe that there are enough voodoo dolls in the vault to make the company solvent even in a further weakened economy.

Great. Then no more government money should be needed. Outstanding. Not a dime more of public funds beyond what remains in the TARP. No need to use public money to buy toxic assets either. Believe me, I would be overjoyed if the madness of public bailouts of private bondholders was to stop. Unfortunately, I don't believe it for a second, because our regulators have clearly demonstrated that they do not want accurate public disclosure of losses (witness Ken Lewis' testimony a few weeks ago, the watered-down mark-to-market rules, and the “negotiated” results of the stress test). Our regulators want confidence. And they're willing to fudge the numbers to get it. If there wasn't a freight train of additional mortgage defaults coming, perhaps confidence building would be a good thing. As matters stand, encouraging confidence is equivalent to encouraging investors to throw good money after bad.

As for bank equities, it is problematic to treat the stocks simply as a discounted stream of future cash flows, because when capital cushions become thin, the only way to properly value these stocks is to treat them like options with an absorbing barrier at zero. Indeed, that is how bank stocks have been trading lately – not as equities, but as option-like securities. I doubt that investors in these companies fully recognize the potential for the spectacular advance in these stocks to vanish if the current confidence about bank balance sheets is not sustained. Meanwhile, we can expect an immediate rush by banks to capitalize on the recent advance by heavily issuing new stock, which would be fine, except that the quality of disclosure is in question. Investors should be sure to read the offering documents carefully.

Ethics, Distribution and Incentives

Over the past few weeks, I've heard a number of analysts suggesting that the bailouts aren't so bad because “we owe this money to ourselves,” and that in terms of present value, they are neutral for society as a whole. What's fascinating about these arguments is that they entirely miss the ethical and distributional effects of the bailouts. This isn't something that would be missed if the Treasury was to borrow a trillion dollars and then hand it over to a fur-coated pimp standing on a street corner in lower Manhattan, but it somehow escapes concern when the recipients are in the offices above the ground floor. It's amazing how quickly capitalists turn into socialists when they stand to lose money.

Here's the situation. A variety of investors provided capital to financial companies, with which they made irresponsible loans and took excessive risks. These activities resulted in real losses, which have largely wiped out the shareholder equity of the companies. But behind that shareholder equity is bondholder money, and so much of it that neither depositors of the institution nor the public ever need to take a penny of losses. Citigroup, for example, has $2 trillion in assets, but also has $600 billion owed to its own bondholders. From an ethical perspective, the lenders who took the risk to finance the activities of these companies are the ones that should directly bear the cost of the losses.

We can always compensate those who we believe lost unfairly, were cheated, or whom we otherwise believe that there is a social interest in compensating. But those decisions should emphatically be made through the political process by our elected officials, not by the arbitrary decisions of bureaucrats that continue to erode the Constitutional separation of powers. As I wrote in March 2008, at the beginning of this downturn, when Bear Stearns was first rescued:

"This is not water under the bridge, and the deal struck last week should not be allowed to stand if we care at all about the integrity of the capital markets. If the market was “certain to crash” in the event that Bear Stearns failed, then the market is certain to crash anyway, because Bear Stearns wasn't the last shoe to drop – it was one of the first. Unfortunately, we're standing in a shoe store. At the point where unelected bureaucrats pick and choose who to subsidize – who prospers and who perishes – in a free capital market, and use public funds to do it, more is at risk than just $30 billion. Instead, we cross a line, and stumble off a very clear edge down an interminably slippery slope."

As long as we don't have a disorganized Lehman-type liquidation, it would be appropriate to take insolvent institutions into receivership, write down the bondholder claims appropriately, then re-issue the companies back to the public. This was more difficult with the auto companies, because there is no regulator with unilateral receivership authority. Still, even Chrysler's holdout bondholders have now thrown in the towel, which will make it easier to restructure in Chapter 11. The process is more straightforward with banks – witness Washington Mutual – but additional authority from Congress would be helpful in order to deal with non-bank entities, including bank holding companies. To minimize the add-on effects of debt haircuts, it would also be helpful for Congress to impose strong capital requirements on newly originated credit default swaps, and to restrict their use to bona-fide hedging.

Notice that by bailing out the financial companies, there is a massive crowding out of private investment, because for every dollar of losses that should have been wiped off the ledger, we are forced to retain and service two dollars of overall debt – the debt securities owed by the financial companies to their bondholders continue to exist, and we now have an equal amount of new debt issued by the Treasury. The rescued bank debt is a drain on the public because it has to be serviced through a combination of higher interest rates to borrowers, and lower deposit rates to savers. Meanwhile, the Treasury debt is also a drain, because except for some income from the Treasury's holdings of preferred stock, the debt has to be serviced from tax receipts.

The bailout is not something “neutral” that cancels itself out, but instead amounts to a transfer of trillions of dollars of purchasing power directly and indirectly from those who didn't finance reckless mortgage loans to those who did. Farewell to the projects, innovation, research, investment, and growth that might have been financed by the savings and retained earnings of good stewards of capital. Those funds are being diverted to the careless stewards who now stand to be made whole.

In short, these bailouts are emphatically not neutral to society as a whole, because they damage incentives and divert productive resources into hands that have proven themselves to be reckless and incapable. To believe that the bailouts are just money we owe to ourselves is to overlook serious ethical implications, as well as distributional and incentive effects.

Market Climate

As of last week, the Market Climate for stocks was characterized by modest overvaluation on virtually every measure that does not assume a return to record 2007 profit margins. Most likely, stocks are priced to deliver total returns in the area of about 8% over the coming decade, which is not hostile valuation, but is certainly not strongly compelling, particularly in an extremely overbought and uncorrected market. Market action remains quite good on the breadth front, but remains fairly tepid from the standpoint of volume sponsorship. Still, we are at the point where stocks could take on something of a speculative life of their own, and we would be forced to meet further advances with incremental removal of the short call side of our hedge. That would allow the market to “take us out” of our hedge in the event of a continued advance (allowing corresponding losses on a retreat back to current levels), but without removing our downside coverage against the significant possibility of a steeper retreat.

The stress here is on “incremental.” My impression remains that the market will be in a very wide 25-35% trading range for quite some time (note also that a 25% loss approximately wipes out a 35% gain, and vice versa). Even if we have entered a sustainable bull market (which I doubt, but cannot rule out), the historical tendency after similar early advances has been for the market to pull back by 7-12% before continuing higher. It's true that stocks have generally done well a full year after an 8-week market rally of 25% or more, but of the seven previous 8-week rallies in the market since 1900, the average dividend yield on stocks at the end of those 8-week rallies was still 6.6%, the median yield was 5.9%, and no instance was below 4.4% (presently, the yield on the S&P 500 is 2.6%). Two of those advances were off the 1932 lows, when the P/E ratio of the S&P 500 on normalized earnings was just over 5 after the advance. One was off the 1982 low, when the yield on the S&P 500 was still 5.1% after the rally, and the normalized P/E was less than 9.

In short, previous market advances of this size have invariably been from far more depressed valuations. The market was still at quite depressed valuations even after those advances, allowing for further progress, on average, over the following year. Again, we can't rule out the possibility that this instance will be different, and that somehow the decline we've had has fully discounted all of the negative economic news ahead. My impression is that this is unlikely, but we don't remain fully hedged once market internals improve sufficiently, unless the market is strenuously overvalued. Any changes in our hedges will be incremental, but we are creatures of discipline, and will respond to the market accordingly.

In bonds, the Market Climate is characterized by modestly favorable yield levels, and modestly unfavorable yield pressures. As I wrote in early January, “given the level of extension in yields, it would not be difficult to generate losses of say 10% in the 10-year Treasury bond, and as much as 20-25% in the 30-year Treasury bond over a very short period of time.” This is exactly what we have observed since then.

The Strategic Total Return Fund continues to emphasize inflation protected securities. Even in the event of further defaults, it is not at all clear that we would observe sustained deflationary pressure. Remember that the deflation of the 1930's was not caused by economic weakness per se, but by a collapse in monetary velocity (essentially people clamoring to hold government liabilities as safe havens, which increases their value relative to goods). Presently, we have a situation where so many government liabilities have been created, it will be difficult to avert inflation except in a situation where there is a flight to safety.

Ironically, perceptions of economic stabilization, if they persist for even a moderate time longer, are likely to provoke a substantial and disconcerting jump in inflation – the main reason being that all of these government liabilities have to be held, and if they are not wanted, their value will decline to reflect that. That said, my impression is that these perceptions of stabilization are an artifact of reading too much from tea leaves of an oversold bounce. The “less bad than expected” news now demands follow-through from actual improvement, and that may be more difficult to obtain. Failing that, I would expect Treasury yields to ease back from their recent spike.

Again, from the standpoint of stability and inflation protection, we continue to prefer TIPS to straight Treasuries here. The Strategic Total Return Fund also carries just under 10% of assets in precious metals, a similar amount in foreign currencies, and about 5% of assets in utility shares.

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