Tuesday, January 08, 2008

Economic Articles of Interest

I ran into two interesting articles on economics today that I thought worthy of re-publishing here. The first is from the folks over at Calculated Risk, who were so kind as to publish their first subscription newsletter on real estate analysis for free. The article can be accessed here. It is kind of lengthy at 14 pages, but it is an absolutely fabulous summary of everything you need to know about the real estate market today.

The second is an (unconfirmed) transcript of a speech made by legendary investor Seth Klarman on leverage and the current credit crisis. (mega hat tip to Lincoln Minor) It was published over at the Motley Fool board, and based on the content appears to be legitimate. It is pasted below.
Some investors target specific returns; a Pension Fund for example might target an 8% annual gain, but if the bundle of asset classes under consideration fails to offer that expected result, they have the choice only to lower the goal, which for most is a non-starter, or invest in something riskier than they would like. The pressure to keep up with a peer group renders decision making even more difficult. That there is no assurance whatsoever that the incurrence of greater risk will actually result in the achievement of higher returns. The best investors don’t target return, they can first focus only on risk and then decide whether the projected return justifies taking each particular risk. When the herd is single-mindedly focused on return, prices are frequently bid up and returns driven down. This is particularly so when leverage is used. Leverage doesn’t have to be dangerous. Non-recourse debt on an asset can certainly make a large purchase more affordable. Taking out a non-recourse loan on an asset you already own can actually reduce risk since the borrowed funds return your capital while the risk of loss is transferred to the lender. But recourse debt, margin debt, is something else entirely. If you purchase some investments and then borrow with recourse debt to buy more, you are now vulnerable to marked to market losses on what you owe. Depending on the precise terms of the debt, the decline of the value of your holdings could force you to either put up more collateral – which you may not have – or to sell off some of the investments you purportedly like to meet margin calls. By borrowing you cease to be the master of your own fate and allow the lender, or actually the market, to be. How ironic to allow the market, which has dished up your current portfolio of opportunity, to dictate to you the need to sell your most attractive holdings in order to survive. The availability and use of margin or recourse debt is especially pernicious. Had you purchased an investment without leverage, which declined in price, you could have used any available cash to buy more. Alternatively you could sell another investment that did not decline or declined less to afford more of the now better bargains. This is in fact a healthy discipline forcing you to choose among investments to own what you like best and necessitates that you carefully decide when to hold onto cash and when to put it to work. Recourse leverage changes this equation as you can seemingly own all the investments you want simply by borrowing to buy them. There is no healthy portfolio discipline enforcing the desire to make new purchases or the anticipation that you may want to. There is also a bit of a slippery slope in the sense that if a little leverage is good, why isn’t more leverage better – when do you stop?

...during our parents’ lifetimes and our own, credit has become increasingly available and standards increasingly lax, to the point where credit cards and checks backed by credit lines arrive unrequested in the mail. Where your house can be used as an ATM, where people with dismal credit histories are eagerly sought after to provide them with loans, where investors flock to buy junk bonds and shady companies seek to issue them, and where investment funds are offered the opportunity to enhance their returns through structured products, derivatives and exotic finances, all of which enable high amounts of leverage. The moral imperative of repaying the banker, your neighbor, who granted you the loan across his imposing desk has been replaced by the moral vacuum of anonymous lenders using credit scoring who quickly resell your loan to someone you’ll never meet, who are actually comfortable with the actuarially determined probability that you may in fact default. Credit rating agencies have embraced the debt or-gy (offensive word detected) with lax standards and na├»ve models, brewing conflicts of interest and accepting healthy fees to label toxic waste as investment grade. A similar risk exists as a result of the burgeoning increase in capital allocated to alternative investments – venture capital, private equity and hedge funds. While returns start to come down as the pension funds have looked to alternatives to add excess return and diversification, they are hardly a panacea. Some alternative managers have historically added considerable value while for others the jury remains out. For alternatives in their entirety, high performance and management fees truncate upside potential – increased competition has forced many alternative managers to incur greater risk to achieve their accustomed returns. For some this means incurring greater credit risk while for others this means utilizing considerable amounts of leverage.

The pendulum may be starting to turn as recent developments in the mortgage and hedge fund markets suggest. Because the scale of today’s leverage so greatly exceeds historical levels , it seems possible that we are only at the early stages of the credit contraction. Not surprisingly, it may take time to work off these excesses. Intervention by the Fed, as it recently has, seems likely to give license to further speculation, while failing to address and perhaps even exacerbating the underlying problem of lax lending standards, poor credit quality and excessive use of leverage. Indeed, many market participants believe the solution to these problems of over-leverage and bad credit is more debt. Recently many funds have been formed to make leveraged purchases of loans that are expected to trade in the mid to high nineties instead of par, with 5x leverage or more, bringing the yield to a 15% or 20% return. It seems to me incredibly unlikely that the end to the debt crisis can be near at hand when the solution offered – more debt – is in fact what caused the problem in the first place. Many investors lack a strategy that equips them to deal with a rise in volatility in declining markets. Momentum investors become lost when the momentum wanes, growth investors who paid a premium for the fastest growing companies don’t know what to do when expected growth fails to materialize. Highly leveraged investors, like some quant funds in the headlines, were recently forced to sell regardless of value when their methodology produced losses instead of gains. Counting on a government bailout for every crisis seems a dicey proposition, especially when supposedly impossible events happen on Wall Street every few years. By the time the market drops and bad news is on the front pages, it is usually too late for investors to react. It is crucial to have a strategy in place before the problems hit precisely because no one can accurately predict the future direction of the stock market or economy.


Anonymous said...

Do you know where this speech was given?

Nnejad said...

No, I tried looking it up but could find no other references to it. All the post says is that it was given in October 2007.