Letter - April 2008

 

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Call the Plumbers!

Anyone who has ever owned a house has experienced the need of a good plumber. A toilet backs up and makes a stink. We all know that there are pipes but don’t have any idea where they are or how to clear them. Call the plumbers!

Plumbing is an apt metaphor for the hidden conduits of the financial system through which capital flows from lenders to borrowers. Driven by the housing boom, financial institutions innovated, stuffing the pipes with complex securities inadequately tested for risk should the housing market run out of steam. Call it Voodoo Finance 101. As the housing bubble burst, investors refused to buy these securities, leaving the banks holding the bag with impaired capital. Stock prices collapsed. That forced the banks to go to foreign investors, hat in hand, to raise equity to stave off insolvency. With so much waste stuffed into the pipes - sub-prime mortgages, SIVs, CDOs, CMBS, leveraged buyout bridge loans - there was bound to be a backup when the music stopped. In retrospect, as always, it seems so clear.

And what a backup there has been. Lenders won’t lend; some borrowers can’t borrow at any price. The financial system has frozen up and is threatening the “real economy,” the one that provides mortgages, car loans and inventory financing for business. Wall Street’s folly is threatening Main Street’s pocketbook.

Call the plumbers!

Federal Reserve Chairman, Ben Bernanke, and Secretary of the Treasury, Henry Paulson, donned their overalls, plungers in hand, and set out to clear the blockages. They acted expeditiously and with imagination. I wish my plumber were as responsive.

Over four days in March, the Fed injected $200 billion into the financial system, cut interest rates, and arranged for the sale of Bear Stearns, a major investment bank that the Street decided was not creditworthy enough to do business with because of its aggressive investments in low-quality securities.

The bailout of Bear Stearns was a watershed event. Wall Street operates on the notion that “my word is my bond,” the ability to honor and settle a trade, and the confidence that the firm on the other side of the trade, the counter-party, will honor the commitment. If confidence in that “bond” disappears, as it did in the case of Bear Stearns, confidence in the system is undermined. Since everyone to varying degrees was playing the same game as Bear, the question became, “who’s next?” Rumormongers targeted Lehman Brothers. By stepping in to guarantee the assets of Bear Stearns and by implication, just about anyone else, the Fed signaled that it would do whatever necessary to stand behind the financial system…another blockage plumbed.

The Fed seems to have gotten it right for now…but Bear Stearns shareholders, including employees who owned 30% of the company, were devastated; they received $10 from JP Morgan for their stock that had sold for over $170 a share only a year earlier…so much for moral hazard, the notion that the government will bail out shareholders.

Despite vigorous efforts by the Fed, financial markets remain vulnerable. Large write-offs of bad debt remain to be taken by financial institutions and that may yet unsettle confidence and the markets. Numerous financial companies continue under stress; they will need to raise capital or sell out to stronger partners. The Fed and Treasury will remain matchmakers, shepherding the weak into the arms of the strong.

Though full confidence has yet to return to the markets, we sense that there is a large pool of opportunistic capital waiting to buy up distressed assets. However, it is still unclear what the risks are, so the recovery unfolds slowly. Cautious stock market rallies reflect uncertainty as to the length and depth of the current downturn in business activity.

Our strategy is to test the investment waters incrementally. Over the last seven months we have made small purchases at what have seemed like attractive entry points. Some of those investments have been premature. We feel like explorers descending a series of cataracts along an uncharted river. After each set of rapids, there is a period of calm. We wonder whether we are through the worst (should we buy?) …or are more rapids ahead?

We continue to emphasize investments with good dividend yields when we can find them. Dividends, often unappreciated, have contributed a surprisingly large part of the long-term returns of common stocks. We believe that many distressed securities today will continue to pay their dividends, resulting in above average returns as confidence returns to the financial system.

As fiduciaries of many of our clients’ investments, we are acutely aware of our responsibilities to preserve capital during difficult times. This, however, has to be balanced by the need to do the right thing by buying depressed securities during periods of low confidence in order to benefit from the eventual return to growth that has characterized the stock market over the long-term. In crisis there is opportunity. It is our challenge to sift through short-term problems to identify eventual winners.

We thank clients for their patience and confidence during this unsettled period.

Tom Herzig


 

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