Global Asset Misallocation

Written in November 2008.

Global Asset Misallocation in 1873

The past year in economic history will for sure get its own special place in all textbooks to be written in the future. The financial deleveraging occurring around the world in the last month alone is staggering. Companies, governments, and citizens had borrowed money against their assets and future income streams to an extreme not seen since perhaps 1873. In 1873, a financial meltdown eerily similar to the conditions seen in 2007 and 2008 had an entire world in monetary panic.

The root cause was a bubble in housing in the U.S. and Europe, coupled with a bubble in commodity prices, which were dominated in the industrial revolution by coal and steel markets. The first shoe to drop was the price of steel in Europe, which led to the bubble pop in railroads, manufacturing, and housing across the continent. Money became scarce in Europe and the consequences spilled over into the United States, as people were speculating on housing and often building 4 or 5 houses at a time to be resold at extravagant profits, much like in the current decade. The drop in housing, rail, steel, coal, and manufacturing interests left the country in a bad recession. However, the economy survived and pulled out of it to explode into a new boom.

Money chases the areas of the economy and the assets which offer the highest return. During a boom or a bubble, too much of the global wealth gets concentrated in one area and causes a misallocation of resources. Eventually, there will be too much supply in this area or not enough new money flowing in and the assets will start to shift elsewhere. Sometimes the shift is subtle, but once every so many decades the shift is enormous. In 1873, money flowed out of the aforementioned industries in a hurry and caused a swift and memorable decline in global assets.

Global Asset Misallocation in the Last 15 Years

In the last 15 years we have seen two extraordinary circumstances where assets around the world have been misallocated, perhaps even three. The first one still lingers in the minds of many investors today. The technology and internet bubble of the late 1990’s was phenomenal. Around the world assets in stocks and real estate soared and times were really good. But, eventually, too much money was chasing too small of a slice of the economy and the bubble burst. Money flowed out of technology and the internet for two years solid, causing many to think the stock market was fundamentally flawed for good. Out of this mess came the greed of Enron and many other companies, where once again there was just too much money involved in such a small slice of the pie. Enron was trading energy, something hardly anyone understood at the time.

So money had to go somewhere offering a good return and housing was the last bastion for the time being. Money continued to flow into housing and real estate around the world, but nowhere did it get quite as crazy as in the United States. People were again doing what they were doing in the 1870’s and building extra houses, which they assumed would be sold at an immediate profit. People who still owed large mortgages on their own homes were financing the construction of more homes because money was flowing so well. The stock market was rising in unison, though times never became as bubbly as they did in the 1990’s.

As economies around the world chugged forward there became a rapid increase in demand for commodities. This was fueled by China and India, who were a net beneficiary of all the money flowing into technology companies in the 1990’s. Simply put, the technology bubble in the U.S. created the rapid growth of China and India. So once again we have a rapid increase in assets around the world, causing home prices to go up simply due to the increase in raw materials, on top of the increase due to excessive demand and speculation.

The Mortgage Problems

The housing excess became a problem sometime during mid 2007. The problem was not very severe or bothersome at first, but then came a new SEC rule in November of 2007. For decades, companies had carried assets on their balance sheet at either the lower of cost or the value at maturity. So, a 30 year home loan would be carried on the books at either the cost of the loan to the bank or the amount they expected to receive out of the loan over time, whichever was lower. This is why Enron is mentioned earlier, and not the other companies involved in corporate scandals earlier in the decade. The SEC wanted to make an accounting rule to prevent future Enrons. Companies would have to carry the value of their assets at current market value, instead of the “silly” old rule.

Now for an economics lesson. In order to have a market, one must have a reasonable amount of buyers, a reasonable amount of sellers, something to trade, and a price (more or less). Without any of these, there is no market. The key here is the words “no market.” The new SEC rule required companies to mark their assets to the current market, commonly referred to as mark-to-market (MTM). Assets would now have to be valued as if all assets were going to be sold on the company’s reporting date. So if the mortgage market was unfriendly on March 31, 2008, which it was, then all the banks had to mark their assets (loans) down to the current unfriendly market price, regardless if the loans were 1, 5, 10, or even 30 years until maturity.

Indeed the basket of loans had fallen in value, due to the rise in foreclosures and the number of homeowners behind on their payments. Forecasts were for everything to get worse, so the price of the mortgages was even lower than if the banks could have based the value of the assets on just the foreclosure rate. In the past, the lower maturity value would have been reflected in the company’s balance sheet one way or another. But now, banks were forced to mark even further down to a market quickly approaching points of financial Armageddon.

The problem was exacerbated by the greed and leverage of the economy. Many companies and banks had excessive leverage ratios of 20 to 1 or even 30 to 1. The companies were literally taking $1 million and borrowing $30 million against these assets. So if the value of the company’s assets declines by 5% to $950,000, they now are over 30 to 1 leverage. Interest rates and the ability of these leveraged companies to perpetuate this level were all based on a certain leverage ratio. Once the leverage ratio started to rise rapidly, the financial institutions were forced to rid themselves of debts or offer more equity to lower their leverage ratios. More selling means prices go even lower in the market. By the June 30, 2008 reporting quarter the mortgage market was in complete disarray. The amount financial institutions had to mark down to the current market prices was staggering and caused several companies to go under. Had they been able to hold their prices at mark to maturity, then they would still be in existence today.

To make matters even worse, mortgage markets have become multilayered. Hometown Bank loans money to 30 home owners, repackages those loans, and sells off some of the future proceeds to Mortgage Broker Inc. Mortgage Broker Inc., then sells credit swaps, which decrease the exposure of Mortgage Broker Inc. to interest rates and other types of risk. Then Mortgage Broker Inc. borrows money on their slice of income coming from Hometown Bank’s loans, in order to lend out more money to another bank so they can repeat the process. So now there are, very quickly 4 layers of indebtedness piled on top of those 30 homes.

The layers go deeper and end up with acronyms which are known all too well to common people today: CDO’s, MBS’s etc… If one layer becomes thinner, then all the layers above it are more likely to collapse. If the value of the homes drops 15%, then the bottom layer has 15% less support and all the layers on top of it are going to get thinner. Each layer is also forced into the MTM accounting, marking assets down as the layers around it get thinner. Soon it all collapses.

The Implosions

The two major implosions to glean insight from are Lehman Brothers and Bear Stearns. These two present very clear history lessons in what happens when a market disappears. Bear’s problem began in the auction rate securities market. These were securities which were very shot term loans, most only a week long. Large companies used this market to borrow money to pay payroll when revenues are inconsistent and on the other side companies used this market to get a descent interest rate over a very short period when they had excess cash. Since the market was incredibly liquid, for a time it worked. A company with $10 million to pay out next week could loan the money out for a week and get some interest, fully expecting the money to be repaid. Well out of nowhere, the market collapsed. There simply was no market. Buyers and sellers dried up. Bear had backed this market with its own assets. When their was no market, Bear’s assets were now required to back up the auction rate securities market, and could not be used to back up other day to day operations. The company simply could not use its assets because a market it decided to back ceased to exist. No buyers, no sellers, no price.

Lehman Brothers had a similar fate. Lehman’s operations were financed to the hilt and the only way the company could survive at any point in time was to continuously issue new debt and pay off old debt. The cycle was perpetual. Well, one day, there was no one there to buy the debt. A market once again ceased to exist. The company could not raise more money to make it through the next day. However, this time the market was specifically in Lehman and Lehman related assets and debts. The government did not step in to rescue Lehman, because markets outside of Lehman’s, were not affected. The government had to step in and help out Bear Stearns, because the market which disappeared financed the day to day operations of hundreds, if not thousands of companies.

The implosions created a market with no buyers or no sellers or both. The parallel is not as clear with mortgage, because there are buyers and sellers, but there are way too many sellers and not enough buyers. Companies have had to unload and reduce exposure to mortgages. There are not a reasonable amount of buyers and there are an extreme amount of sellers. So the market in mortgages really does not exist. Still, the companies are being forced to MTM their assets to this arbitrary market which prices everything askew. The SEC is working on fixing this rule, but I’m not sure as of yet they have found a practical solution.

The ripple effects of these implosions and the others, like AIG, have fueled the rapid decline in all asset classes. There is simply less money to go around. Now the little guys are getting involved in the mess by pulling money out of mutual funds and hedge funds. Every mutual fund redemption causes a mutual fund to sell stocks or whatever asset the fund has on the books. Hedge funds have 15 to 1 or larger leverage, so every $1 in redemptions causes $15 or more in stocks, bonds, or other assets to be sold. To be sure, there will be more bank foreclosures and more bankruptcies. The unwinding is not over.

The Commodities Markets

How soon we forget our dread over the sky rocketing price of oil. Again there was just too much money chasing too few assets. The stock market started its decline last year, and as the money came out of the stock market, it had to go somewhere. Housing was declining in value, stocks were not in vogue, so the money flowed to commodities. The price of oil, corn, gold, silver, natural gas, and most everything else considered raw materials flew to new heights. Once again there was a global asset misallocation. Yes the price of oil was destined to go up, but a move up from $80 to $100 is far different than a move up from $80 to $140.

In the long run, the short term hike in oil and gas prices will help strengthen the world’s energy position. Increased drilling and technological advances will come out of the increased budgets of oil companies. Solar, wind, geothermal, and wave power have been given more life than if the oil price had remained below $100 the whole time. Alan Greenspan observes higher oil prices by necessity create more petroleum reserves, because more players want oil as an investment. So now we have more worldwide, above ground reserves than before, theoretically.

We survived the oil inflation and the commodities bubble, but it too has burst. This forces even more deleveraging by institutions. Many commodities funds were 10 to 1 or greater leverage. When the plug was pulled, it was the mortgage melt down all over again. So now we have flight from commodities, stocks, housing, and the whole lot of asset classes, except U.S. Treasuries.